How To Profit From Value Traps

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Includes: DIA, IWM, QQQ, SPY
by: Jeff Miller

Summary

Michael Santoli, reflecting widespread sentiment, calls 2016 the year of the value trap.

His approach assumes that the market is correct about the economy.

Maybe (as usual) it would be a mistake to chase what worked last year or last month.

There are some great ways to profit from the alleged value traps.

Wall Street loves to name things. The unofficial definition of a "value trap" is a cheap stock that is stuck around the current price.

Those who focus on what happened in the past have a big advantage. They can cite facts, past performance, and explanations that make them seem to be really smart. They are helping you to understand what has recently happened, and also sharing the current conventional wisdom. How can anyone disagree? The story would get an "A" in a journalism class.

Explanation of what has already happened is fine for a journalist, as long as readers are cautious about extrapolating the results. Piling into crowded trades might work for a while, but eventually leads to big losses. The very best journalists do not become great investment managers.

As an example, I once read an article in a print magazine about the worst current stocks to hold. The author had some sort of earnings screen which cranked out stocks with low earnings. I owned four of the ten! What the author did not understand was that my stocks were all asset plays, valued on the basis of things like real estate holdings and other hard assets. I used his list to explore other possible ideas.

Michael Santoli and Value Traps

Michael Santoli, who has broad experience in market commentary, recently became a Senior Markets Commentator at CBNC. I have followed his work for many years and turn off the "mute" if his topic seems interesting. That means I regard him as interesting and pretty good. He recently presented on the theme of this blog post: Is 2016 the Year of the Value Trap? He accurately observed that cyclical stocks trade at low PEs at times of economic tops and high PEs when the market is low. This widely known observation (Peter Lynch from 30 years ago, for example) is certainly accurate. Santoli listed several current value trap stocks. He informed us that the market was suggesting the top of the economic cycle.

Since I have a value approach, driven by a sophisticated analysis of economics, I looked at his list with interest. Several of my holdings were on his list — Ford (NYSE:F), Gilead (NASDAQ:GILD), and GameStop (NYSE:GME) — and I added another today! (Delta, DAL)

Santoli's Error

Santoli's work is an accurate representation of current thinking, and therefore solid journalism. The problem is that he is attempting to explain what already happened. He does this very authoritatively. His real message is that traders have a fixation on yesterday's news. Here are the problems:

  • If the market has all of the answers, investors, traders, and CNBC watchers cannot gain any edge. Warren Buffett says that he would be on a street corner selling pencils if markets were efficient. Does Santoli really believe that he or his viewers can make money from an authoritative explanation of yesterday's news?
  • He is ignoring the important investing concept of being contrarian. That is where you can make real gains.
  • He is ignoring the strong mean-reversion tendencies of relationships - like that between growth and value stocks.

My Alternative Approach

I have seen this argument many times before. Past "value trap" candidates were Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Cisco (NASDAQ:CSCO), to pick a few prominent examples. Putting a label on something is not analysis.

In sharp contrast, my approach is that 2016 is the year of the value stock. It is better to profit from finding market errors than a slavish devotion to what worked last month or last year. The current market is punishing cyclical stocks with recession valuations, with no recession in sight. We have two great ways to play this theme:

  1. If there is a near-term catalyst, we just buy the stock in our long-only program.
  2. If we expect time before the catalyst, we sell near-term calls with a target of 9% return. If the stocks are safe, the return is safe.

When others see a value trap, I see an income opportunity. Take what the market is giving you!

Not Convinced?

The flip side of the Santoli reasoning - the market is right - is that we should all be buying anything with a dividend, even if we are paying a multiple of 26 for 6% growth.

Few articles and TV programs provide real help, since being contrarian - by definition - goes against the grain. You cannot look smart like Mr. Santoli. We will not have the final verdict for months. It would be refreshing if we had some journalists who were willing to go against the grain.

Disclosure: I am/we are long F, GME, GILD, DAL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: F, GME, and DAL versus short calls